Supervision of Development Finance Institutions

Presented to

The 2013 Annual Association of African

Development Finance Institutions Forum Serena Beach Hotel, Mombasa, Kenya

Thursday, 14th November 2013

CENTRAL BANK OF KENYA

Outline

1. Structure of the Kenyan Financial Sector

2. Vision 2030 and DFIs

3. History of DFIs in Kenya

4. Tenets of Effective Legal & Regulatory

Systems

5. Overview of AADFI Prudential Standards

6. The Way Forward for Kenyan DFIs

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1. The Kenyan Financial Sector: Structure & Regulation

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The National

Treasury

Central Bank of

Kenya (1966)

Capital Markets

Authority (1989)

Retirement

Benefits

Authority (1995)

Development Financial Institutions

e.g. IDB Capital, AFC, KIE, ICDC,

TFC (formerly KTDC)

Insurance

Regulatory

Authority (2007)

Commercial Banks

(43); Mortgage

Finance Co. (1); Forex

Bureaus (106); Deposit

Taking MFIs (9); CRBs

(2);Rep. Offices (7),

Building Societies (0)

Securities Exchanges;

CDSs; Custodians;

IBs; CISs; IAs; Stock

Brokers; FMs; Stock

Dealers; Listed Co.s;

CRAs and VCFs

RBSs; Pension

Schemes; NSSF;

Administrators; FMs;

Custodians

Insurance Co’s ; Insurance

Brokers ; Insurance

Agents; Assessors &

Adjustors; Health

Management Co’s

Ministry of

Industrialisation

and Enterprise Devt

SACCO Societies

Regulatory

Authority (2009)

Sacco Societies

with Front Office

Service Activity

(FOSAs)

The DFIs are not under a direct regulator

2. Vision 2030 & DFIs

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Government of Kenya long term development blueprint aimed at:

Transforming Kenya into “a newly industrialising, middle income country providing a high quality of life to all its citizens in a clean and secure environment” by 2030

Vision for Financial Sector in Vision 2030: “Create a vibrant and globally competitive financial sector:”

Promoting high level of savings

Financing Kenya’s investment needs

It is only through concerted efforts of all financial sector players that a vibrant and globally competitive financial sector can be created

DFIs are key players in the financial sector – They should provide long-term finance; provide SMEs with development finance

A market for long-term finance with initiatives of credit information sharing will deepen and develop the financial sector

2. Vision 2030 & DFIs…

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Under Vision 2030, DFIs are expected to contribute towards enhanced financial access and investment goals (especially improving investors’ access to long term finance)

DFIs require capacity to grow and a regulator to grow the market

DFIs expected to mobilise resources for long term lending to productive sectors of the economy

For DFIs to play this role and fulfill market expectations, some ground rules should be set and finance allocated

Targeted intervention for specific sectors or groups like SMEs, Youth, Women, etc will work even better with DFIs in control

3. History of DFIs in Kenya Some Kenyan DFIs converted to commercial banks in the1990s But the journey was not smooth. They had to re-convert back to DFI status in the

early 2000s due to their inability to comply with the prudential requirements such as: ◦ Undercapitalization - Minimum core capital requirement of Ksh.250 million not met ◦ Violating lending limits – More than 25% of core capital limit lent to several borrowers ◦ Excess foreign exposure limit – More than 20% of core capital limit exceeded due to large foreign

funding for onward lending ◦ High Non-Performing Loans level – 50% of loans not performing ◦ High concentration risk – 95% of loans with top 50 borrowers

The DFIs non-compliance with the prudential requirements could have mainly been driven by: ◦ Non-conformity of DFIs primary mandate (long term lending) and the banking regulatory framework -

Banking regulatory framework uniformly applicable to all banks with no exception ◦ DFIs inability to mobilise long term local deposits to match profile of assets – Reliance on foreign credit

lines to support mainly long term assets ◦ Failure of DFIs to customise their policies & practices towards commercial bank orientation ◦ Weak corporate governance structures – From years of lack of prudential guidelines

Mandate of DFIs (Economic Development) and Commercial Banks (profit motive) at variance => there is therefore need to customise the regulatory frameworks

There is a market for long-term finance to support firms in all sectors of the economy

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4. Tenets of Effective Legal & Regulatory Systems An effective legal & regulatory framework should be commensurate with

the risks posed to the financial system by the targeted players

Such a legal framework should provide for:

◦ minimum entry/prudential requirements, which are the basis for ongoing

supervision, including core capital levels;

◦ powers to address non-compliance; and

◦ legal protection for supervisors

Clear responsibilities and objectives for the supervisor(s)

The supervisor(s) should possess operational independence and adequate

resources

Effective market discipline - financial transparency and effective corporate

governance

Procedures for the efficient resolution of problems in financial institutions -

Supervisors should have sufficient and flexible range of procedures for

efficient resolution of problems

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4. Tenets of Effective Legal & Regulatory Systems… The most critical challenge - Overbearing regulation stifling innovations

=> Need for Better Regulation Better regulation is characterised by a regulatory framework with

ability to: readily identify weaknesses and emerging vulnerabilities; analyse and price risks appropriately; provide appropriate incentives (and penalties) to induce prudent

behaviour in the market place; and encourage innovations and develop strong institutions of the regulators

and the regulated – strong institutions define appropriate rules and the appropriate incentives

Regulators have a role to: ◦ Guide markets to develop with safety, credibility and stability ◦ Promote a hands-on approach to innovation. Being on the forefront to

encourage innovation ◦ Promote a dynamic collaborative relationship with market players

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5. Overview of AADFI Prudential Standards The AADFIs standards will not only create a level playing

field for DFIs but will also act as benchmarks towards the

desired mandates

The three pronged AADFI standards, has to a large extent

incorporated a mix of an effective regulatory framework:

◦ Governance and Management Standards:

Sufficient independence from Government

Management independence and commensurate incentives

Operating in accord with reasonable commercial principles

Proper accounting and auditing principles embraced

Appropriate Management Information Systems and procedures

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5. Overview of AADFI Prudential Standards… ◦ Financial Prudential Standards:

Capital Adequacy – well capitalised DFIs better placed to withstand shocks

Profitability and efficiency – Profitable DFIs attractive to financiers and

limited demand for additional public resources

Asset quality, diversify and safety – Contributes to stable financial sector

Liquidity and funding – Promotes a match of assets and liabilities

◦ Operational Standards:

Risk Management Policies – identification, monitoring and mitigation of all

potential risks

Lending policies – Lending is the core business of DFIs. Appropriate lending

policies (approval, disbursement, monitoring/supervision & collection) ensures

sustainability of the business

Operations Strategy Policies – Ensures that DFIs operate within permissible

boundaries as defined in the enabling legislations

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6. The Way Forward for Kenyan DFIs DFIs role in financial intermediation (resource mobilisation & allocation)

cannot be overemphasized:

The 5 DFIs (IDB Capital, ICDC, KIE, AFC and KTDC had lent a total of Ksh.6.8 billion (approximately USD80.73 million) as at June 2012

The targeted sectors include: Small & Medium Enterprises, Trade, Manufacturing, Tourism and Agriculture

DFIs use public funds - targeted intervention case

This role can only be effectively discharged by having some form of regulation & supervision

A combination of prudential and market conduct regulation may be necessary

Several countries including Tanzania, Nigeria, China, Swaziland and Korea already regulate and supervise DFIs. As a result, countries such as Kenya, need not reinvent the wheel

It is a matter of customising the regulatory & supervisory frameworks to local circumstances

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6. The Way Forward for Kenyan DFIs… An effective regulatory and supervisory framework should

adequately address all potential risks

The DFIs regulatory and supervisory framework should be

tailored to suit their unique features, especially:

◦ Economic development orientation

◦ Long term structure of assets

Better regulation as opposed to more regulation is key in

building strong institutions, encouraging prudent market

behaviour and incentivising the market

Regulation and supervision must continuously evolve to keep

pace with innovation

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